For tax years 2018-2025, federal law has imposed a $10,000 state and local tax deduction cap. In response, multiple states are enacting workarounds through legislation that allows pass-through entities to pay tax on behalf of their owners that the owners then claim a credit for on their personal tax returns. Two recent examples of this are California and Massachusetts.
In California, entities taxed as S corporations or partnerships (including limited liability companies) can elect to pay tax on behalf of their owners as long as: no owners are partners, the entity is not part of a combined reporting group, and they are not publicly traded partnerships. In California’s case, the elective pass-through entity tax is a 9.3% tax imposed on the “qualified net income” of the entity. “Qualified net income” is defined as “the sum of the pro-rata shares or distributive shares of income of any partners, shareholders or members upon their consent.” Interestingly, the entity can make the election to pay the tax even if the partner, shareholder or member does not consent. Also important to note, this 9.3% elective tax is on top of, rather than in place of, any other taxes or fees that apply to the entity.
In order for an entity to make the election to pay this entity-level tax in California, it may do so annually on an “original, timely filed return” and is irrevocable. For the tax year 2021, the tax must be paid by the original due date of the entity’s tax return (not counting any extensions). For tax years 2022-2025, at least 50% of the prior year’s tax (or $1,000 – whichever is greater) must be paid by June 15th “of the taxable year of the election,” and the balance of the tax is due by the original due date of the entity’s tax return (not counting any extensions).
Owners taking the credit on their personal tax return do so by claiming a credit equal to the tax paid on their behalf. If the credit is more than the tax they owe, the excess can be carried over for up to five years.
Massachusetts passed a similar law to California, with a few minor differences. In Massachusetts, the tax is 5% and owners can claim a refundable credit equal to the tax paid on their behalf multiplied by 90%.
Both of these state laws will be considered inactive if the state and local tax deduction cap at the federal level is repealed or expires. These two state pass-through entity tax programs become available for tax year 2021, similar to the program New York enacted in 2021. New York has yet to release guidance on how pass-through entities elect into this program and does not yet have a method available to pay the pass-through entity tax. For information on the New York pass-through entity program, please go here: https://efprgroup.com/news/article-publication/business-services/new-york-passthrough-entity-tax-election/
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The materials contained herein are intended for educational and informational purposes only and do not constitute tax or legal advice. Readers are responsible for obtaining such advice from their tax and legal counsel.